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May 8, 2006

Avoiding the Big Loss

John P. Hussman, Ph.D.
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In their breathless enthusiasm about the market's push to six-year highs, analysts might benefit investors by noting that stocks have lagged the return on lowly Treasury bills for nearly eight years, and thereby remind them that valuations matter.

From mid-1998 through Friday's close, the S&P 500 index has delivered total returns of just 3% annually. The index remains well short of the all-time high it achieved in 2000. The Russell 2000 index has performed better over the past 8 years, achieving white-hot total returns averaging 7% annually. Of course, the notion of “multi-year highs” can be deceptively exciting, as if the market should be chased at these levels for fear of running away forever. From a broader perspective, however, the market has simply gone from rich valuations six years ago, to rich valuations today. Unfortunately, investors are probably less than half-way through a long, exciting trip to nowhere.

To say that something has moved back to a six-year high is, by definition, to say that it has done precisely nothing for six years. It's an interesting statement when it's true for things that shouldn't trend upward over the long-term, such as P/E ratios, or interest rates, or inflation rates. But it's slightly pathetic when the phrase is enthusiastically applied to stock prices.

Meanwhile, a mere (and long-overdue) 10% pullback in the S&P 500 would erase two years of advantage over T-bills. That's not a situation that deserves excitement, but rather bored indifference. If investors have learned anything in these six years during which stocks have gone nowhere, it should be that valuations matter. Regardless of short-term outcomes, informed long-term investors can only cringe at current valuations and say “here we go again.”

Avoiding the big loss

Warren Buffett once articulated two rules of investing.

Rule #1: Don't lose money.

Rule #2: Don't forget Rule #1.

There's no way to overstate the importance of avoiding deep losses as an element of long-term investment success. Deep losses are extremely difficult to recover. This is evidenced by the fact that even the Russell 2000's powerful advance since 2003 has merely turned bad returns into pedestrian ones.

Avoiding deep losses requires investors to recognize that market risk sometimes isn't worth taking, particularly when stock valuations are rich and competing yields are rising. On average, about 40% of the gains in the typical “bull market” are wiped out by the subsequent “bear market,” though the individual figures vary widely. The retracement from rich valuations is often deeper. Unless one believes that market turns can be precisely identified and that short-term market forecasting is a fruitful effort (I don't – good managers know their skills but aren't unrealistic about them), it turns out that it is often necessary to forego some portion of bull market gains in order to avoid periods of substantial market loss.

Here's a historical fact that I don't recommend as a timing tool or investment strategy, but is true nonetheless. Had an investor sold the S&P 500 index anytime it reached a price/peak earnings ratio of 19 (i.e. 19 times the highest level of earnings achieved to-date), and then simply sat in Treasury bills, possibly for years, reinvesting in stocks only when the S&P eventually declined to 14 times earnings, that investor would have captured the entire historical return enjoyed by S&P 500, with substantially lower volatility and risk exposure.

Even easier, suppose that an investor sold the S&P 500 at 19 times record earnings, and just sat out of the market until the S&P 500 eventually dropped 30% from its prior highs (say, on a weekly-closing basis). Nothing more. Just sell at the first point of overvaluation and then sit around waiting for a plunge. That strategy would have placed an investor out of the stock market nearly 30% of the time, yet would have produced total returns of 13.03% annually since 1940 (versus 11.90% for a buy-and-hold approach), and 13.67% since 1970 (versus 12.96% for a buy-and-hold).

Now, one might say sure, but that's because you've eliminated several deep, unusual “outliers” like the ‘69-70 decline, the ‘73-74 plunge, the ‘87 crash, and the 2000-03 bear market. But that's exactly the point. All of those plunges had their origins in rich valuations.

Looking closer, you would notice that these rules would have kept investors out of stocks during a good portion of what turned out to be bull market advances. In some cases, an investor would have been out of stocks for years before a 30% plunge or a price/peak earnings multiple of 14 came around. Again, however, that's exactly the point. As soon as stocks became richly valued, every bit of time investors remained in stocks would ultimately have been made worthless by the losses that followed. The entire round-trip would have represented needless risk.

Again, I certainly don't advise either of these as strategies – they are not even close to being optimal, involve far too much tracking risk, and would have historically required implausible levels of patience. The point is that historically, high valuations have led to bad outcomes, and that even the crudest sort of risk-management would have been effective for long-term investors, even if bad outcomes did not emerge for years.

In my view, managing risk by considering both valuations and market action vastly improves the ability to capture market advances while still avoiding a good portion of major declines (and a substantial portion of minor ones). Even here, however, we can (and do) get into situations where both valuations and market action are unfavorable, and stocks advance over the short-term anyway.

That imperfection is unfortunate. When it happens, a defensive position can (at least temporarily) seem pointless. My concern at those points isn't about being “wrong” (though I do examine market conditions for any special or unusual factors). Rather my concern is that even a few of our shareholders might take the short view in the belief that the market is running away, and compromise their own long-term financial security in order to catch the last bit of a market advance.

Given that the past 6 years represents a nice peak-to-peak laboratory for the market (albeit at much higher valuations than normal, resulting in a more defensive position for us than would normally be the case), how have these risk management considerations worked out in practice? The Strategic Growth Fund's latest performance chart displays Fund returns relative to the S&P 500 and Russell 2000 indices since its inception in 2000, including the unhedged performance of the Fund's stock holdings, after fees and expenses, for purposes of comparison and performance attribution.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action. The S&P 500 price/earnings ratio is once again at 19 times peak earnings, making the above discussion fairly topical. The major indices are uniformly overbought as well, which creates added potential for weakness. Still, it's not our attempt to forecast short-term fluctuations. Suffice it to say that recent market action has done little to improve the quality of internals, and that the Strategic Growth Fund remains fully hedged against the impact of market fluctuations.

In bonds, the Market Climate is characterized by relatively neutral valuations and still unfavorable market action. A substantial increase in yields from here would most probably result in a gradual increase in the duration of the Strategic Total Return Fund (which currently stands around 2.5 years). The Fund continues to hold about 8% of assets in precious metals shares, though I would be inclined to reduce this exposure modestly on substantial continued strength in this group.

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